There has been a steady stream of reports regarding the dire effect of AIG going bankrupt in the event of a shutoff of taxpayer funds.

 These have breathlessly warned of the financial system tottering as bank counterparties fall like dominos; of panicky policyholders around the world cashing out policies, forcing AIG's many insurance divisions to dump securities on an already prostrated market; and, as reported in the L.A. Times today, even of an airline industry imperiled as AIG's restructuring brings down an aircraft leasing company.

I don't want to downplay the potential adverse impact of  an AIG bankruptcy.  As a company with 71 insurance companies here and 176 other financial services subsidiaries around the world, AIG cannot be allowed to fail - that is, the healthy components of this giant cannot to allowed to fail.  We do, however, need to recognize that parts of AIG have failed already.  

The key question that needed to be raised is this: why does AIG, as a taxpayer-owned entity, continue to remain in its toxic pre-bailout state as a hedge fund grafted onto a insurance company?

What would be the beneficial - and the adverse - consequences of spinning off the London financial-products division, where the deadliest derivatives trades are concentrated, from the rest of AIG?

From the point of view of the other subsidiaries, there is clearly no down side.  Instead of their profits subsidizing a vampire division, they would be free to stand on their own merits, subject to spin offs of their own over time, with the healthy components remaining together as a complex if viable entity with a greatly enhanced value.  As majority shareholders in the restructured entity, taxpayers should also be pleased with such a divestment: finally there would be a concrete reason to hope at least a portion of their multibillion dollar investment will prosper over time.

But what of the London financial products division, and its toxic load of killer credit default swaps?

To begin, whether financial products remains a subsidiary of the AIG or not, the taxpayers effectively own its radioactive portfolio, and, under current bankruptcy law, can't obtain relief from its counterparty claims in the courts (as the Financial Times reported on Friday).  So while severing financial products from the parent company will enable AIG's survival as a healthy insurance giant, it still leaves open the question of what we do with the garbage it leaves behind in our lap.

This is why it's critical that congress immediately rescind the provision of the 2005 Bankruptcy Law that puts derivatives contracts beyond the reach of a bankruptcy judge.  If the housing market is in bad enough shape that bankruptcy judges are now empowered to alter terms of a mortgage contract, why shouldn't they be allowed to amend derivatives contracts whose strict enforcement favor a few well-placed counterparties at the expense of the entire global credit system? 

Once derivatives are no longer a privileged category under bankruptcy law, the Treasury can surely sit down with representatives of financial products and their counterparties (as well as with foreign government officials if necessary) and negotiate a solution that, while still imposing bearable losses on the counterparties and a sustainable burden on the taxpayer, insures that all involved respect the higher interests of the public and the well-being of the world financial system.

What about the adverse consequences of a financial products spin off?

For the counterparties to the financial products division, they are huge.  As things stand, the AIG bailout can be presented as a bailout of the "world's largest insurance company", not a bailout of an "out-of-control overseas subsidiary with powerful counterparties protected by a fatal loophole in bankruptcy law". The dire consequences of the failure of the parent, with its worldwide scope and scale, can be used to effectively frighten money out of taxpayers.  The debate over AIG becomes framed in such a way that makes public subsidies appear absolutely necessary, essential to the continuance of Western Civilization as we know it - thanks to the self-serving creation of an artificial and absolutely dissolvable black hole too massive to fail. 

At the same time, prolonging the status quo allows healthy divisions to continue to offset financial products' losses, an added cushion for the counterparties that would vanish in a corporate divorce.

I don't see similar adverse consequences for AIG's other divisions, or for the taxpayers (or for Western Civilization, for that matter) from a financial products spin off.  While taxpayers may end up having to bear additional losses - losses in financial products that otherwise would be covered by AIG's other divisions - these losses can be reduced through astute negotiations.  Taxpayers also have as recompense the upside of the reconstituted parent.  At least with separation the toxic waste of one subsidiary no longer threatens the health and well-being of its siblings, and through them the world economy. 

There is one additional benefit I haven't mentioned of what I propose: the consequences of bold, decisive, public-interest-centered decision-making in the AIG case on the markets and the future behavior of market participants.  While the counterparties may prefer operating in the shadows, leaching off healthy companies and the public coffers and indefinitely prolonging business as usual, it's clear that the rest of us cannot afford the status quo.  Powerful measures must be taken and examples made.

We need to recognize that AIG is a Three Mile Island that's already happened.  The worst we can do now is not clean it up, and so create a more fatal Chernobyl down the road.